Inflation and Deflation and How to Invest for Each.

There are two economic phenomena being widely discussed by economists every day.  These occurrences, inflation and deflation, should in some way, determine how individuals invest their funds.  Understanding these two forces will equip us in the way we want to approach not only investing, but buying and selling as well.

Let’s start with a couple of good, simple definitions to get us started.

• Inflation.  A general increase in prices, often caused by an increase in the supply of money or credit.
• Deflation.  A general decrease in prices, often caused by a reduction in the supply of money or credit.

Look at the definition again.  Note that there is a cause and effect to the increase or decrease of prices.  That cause, as shown in the definition, is the increase or decrease in the money or credit supply.  It other words, it really does boil down to the simple economic laws of supply and demand.

The desire of today’s economist is to create a very low and very steady rate of inflation.  How is this done?  Generally this assignment is charged to central banks, or the Federal Reserve. The Federal Reserve accomplishes this charge by:

1. Decreasing or increasing interest rates.  If inflation begins to trend too high, the Federal Reserve can increase interest rates, thereby increasing the cost to borrow.  This increased borrowing cost then reduces the demand for credit.  Reducing the demand for credit then slows the economy, hopefully, slowing the increase of prices.
2. Manipulating banking reserve requirements.  Reserve requirements are the amount of funds that a bank must hold in reserve against specified deposit liabilities.  This increase in required reserves also has the effect of “cooling” the economy and lowering asset prices.
3. Through open market operations.  The most effective tool the Fed has, and the one it uses most often, is the buying and selling of government securities in its open market operations.  This action directly increases (by selling government securities in the open market) or decreases (by buying government securities in the open market).

Each of these three areas allows the Federal Reserve to manage the rates of inflation or deflation we experience as investors in everyday life.  It is important to note that although there is an ongoing intent by the Federal Reserve to create a low inflation rate environment, the desired outcome is not always possible.  In fact, the private sector though the buying and selling of goods and services will always be the primary driver of price levels.

Consumer Price Index

The Consumer price index (CPI) measures the average price of a basket of goods and services. This basket is projected to mirror all of the items an average family buys to achieve some minimum standard of living in some base period (currently, 1982-1984). The basket is adjusted periodically.

Investing in Times of Inflation

There are many investment choices that an investor will find advantageous during inflationary times.  Here are a few:

• TIPS.  An acronym for Treasury Inflation-Protected Securities, these securities’ principal is tied to the Consumer Price Index. With inflation, the principal increases. With deflation, it decreases. When the security matures, the U.S. Treasury pays the original or adjusted principal, whichever is greater.
• Gold and Oil.  Gold, oil, and other commodities will typically track with inflationary movements.  As stated earlier, inflation is a general price increase.  Gold, oil, and other various commodities generally have price increases that move in accordance with inflation.
• I-Bonds.  This type of U.S. Government Debt comes with a fixed rate of return and a variable semiannual inflation rate (based on CPI-U for March and September).  These two rates are combined to offer some protection during times of inflation.  The interest compounds semiannually for 30 years.
• Real Estate.  Whether through actual real estate that you can see and touch, or through real-estate investment trusts purchased as a security, real estate offers some protection from inflation.  Real estate, like any other asset, will generally move in accordance with general asset prices.

Investing in Times of Deflation

Unfortunately, there are precious few investment choices that an investor will find to be advantageous during deflationary times.  The most important acts an individual can make during deflationary times are to stay employed, pay off debt and invest in yourself.  For those that are doing these but would like to invest elsewhere as well, I would offer these instruments.

• Short-Term Government Bonds.  You'll get very little in the way of interest during times of deflation, but you're guaranteed by the United States of America not to lose money.
• Cash and CD's.  Make sure that you abide by FDIC limits of $250,000.  Again, interest rates are generally not good during deflationary times, so don’t expect much.